1 March 1990 Ruling 58311 F - Capital Gains Deduction - Average Annual Rate of Return of Dividends

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Dear Sirs:

Re: Capital Gains Deduction Subsections 110.6(8) and (9) of the Income Tax Act (the "Act")

This in reply to your letter, dated June 16, 1989, whereby you requested an opinion concerning the application of the capital gains exemption provided by subsections 110.6(2.1) or (3) of the Act in the following hypothetical situations.

A.     Situation 1

     Mr. A owns 100% of Holdco's issued and outstanding common shares, which have a fair market value of $10,000,000, and an adjusted cost base of $1.  Holdco's sole asset is an investment in a class of preferred shares of Opco, which carries on an active business in Canada.  Opco's fair market value is $10,000,000, being the redemption and retraction value of the preferred shares, which are owned by Holdco.  The Opco common shares have a nominal value.

     No dividends were ever paid to Holdco in respect of its preferred shares held in Opco.  You have assumed for the purposes of your example that such dividends amount to $1,000,000.  We assume this refers to the cumulative  unpaid dividends on the preferred shares.

     Two alternatives are assumed:

a)     Mr. A transfers 100% of his Holdco common shares to Newco and they elect under section 85 of the Act that the proceeds of disposition for Mr. A and the cost to Newco of the coin shares in Holdco will be deemed to be $400,001.

b)     Mr. A transfers to Newco that number of Holdco coin shares whose total fair market value is $400,000.  We have assumed that any election in respect of this transfer would establish Mr. A's proceeds of disposition to be $400,000.

B.       Situation 2

     In a second situation, Mr. X owns 100% of the issued and outstanding share capital of Holdco, being:

-       preferred shares with a redemption/retraction value and paid-up capital of $1,000,000, and an adjusted cost base to Mr. X of a nominal amount, and

-       common shares

     The preferred shares of Holdco were acquired as consideration on the rollover of Opco shares pursuant to subsection 85(1) of the Act in order to effect a freeze of Opco's fair market value of $1,000,000 at that time.

     Mr. X intends to dispose of the preferred shares and realize a capital gain.

     Holdco's sole asset is its investment in Opco coin shares.

     In the past, no dividends were paid by Opco to Holdco or by Holdco to Mr. X, since Opco was in a loss position.

     Opco's current fair market value is well below $1,000,000. Hence, when Holdco's preferred shares are disposed of or redeemed, proceeds will be well below the stated redemption/retraction amount.

     We have assumed that the coin shares of both Holdco and Opco are prescribed shares for purposes of subsection 110.6(8), but that the preferred shares of Holdco are not.

     You requested an opinion regarding the application of subsections 130.6(8) and (9) in view of the fact that no dividends were paid on the shares in any of the above-mentioned situations.

Our Comments

Subsections 110.6(8) and (9) of the Act are anti-avoidance rules enacted to prevent the conversion of dividend income into exempt capital gains of individuals.  Subsection 110.6(8) of the Act applies to deny a capital gain deduction where a significant part of the capital gain is attributable to the fact that dividends were flat paid on a share (other than a prescribed share) of a corporation or that dividends paid on such a share in the year or in any preceding taxation year were less than 90% of the average annual rate of return thereon for that year.

Whether it may reasonably be concluded that a significant part of a capital gain is attributable to the non-payment of dividends is a question of fact which can only be determined upon a complete review of all of the relevant circumstances surrounding a particular capital gain.  Accordingly, we cannot provide the opinions which you requested.  However, we can provide the following comments.

In Situation 1, it is not clear to us how it could be concluded that any part of the capital gain on Mr. A's Holdco coin shares was attributable to the non-payment of dividends by Opco.  If $1,000,000 in cash dividends had been paid by Opco on its preferred shares, it is likely that the fair market value of Holdco's preferred shares would have been reduced by a similar amount, as a result of Opco's inability to then redeem the preferred shares at their redemption amount.  However, Holdco would have received $1,000,000 in cash upon the payment of the dividends, so that the total value of Holdco's assets, and hence the value of Mr. A's shares of Holdco, would have been unaffected by the payment of dividends.

In situation 2, we would generally expect that it would not be reasonable to consider that a significant part of the capital gain realized on such shares is attributable to the fact that dividends were not paid on such shares.  Rather, we would generally expect that the entire gain would be attributable to the inherent gain on the common shares of Opco at the time they, were transferred to Holdco.

As a general matter, however, we do not agree with your proposition that only "participating" shares (i.e. shares that have a dividend entitlement over and above the stated preferred dividend rate or rights to participate on dissolution) are subject to the application of subsection 110.6(8).

The aforementioned comments are only expressions of opinion as explained in paragraph 24 of Information Circular 70-6R.

Yours truly,

for DirectorReorganizations and Non-Resident DivisionSpecialty Rulings DirectorateLegislative and Intergovernmental Affairs Branch